Fiscal Cliff Negotiation Failure Could Be The Best Option

If they can't agree to bring the budget deficits down to a sustainable level when the next elections are 2 years away, when will they ever do so?

Maybe never. According to Politico, the tax increases and spending cuts of the compromise deal being worked out between President Obama and the Republican House leadership would only reduce the federal budget deficit by about $260 billion per year ($120 billion from tax increases, $120 billion from discretionary spending, and $40 billion from entitlements.)

The 2012 U.S. federal government budget deficit was an estimated $1,327 billion per year. Subtracting just $260 billion from that amount would leave a budget deficit that is still well above the $1 trillion per year level, and the national debt would continue to rise at a clip that is much faster than the growth in GDP.

In contrast, going off the fiscal cliff would reduce the budget deficit to a possibly sustainable level. The automatic tax increases and discretionary spending cuts would reduce the budget deficit by $502 billion per year, so that the resulting deficit would be about $825 billion per year.

If the fiscal tightening was removed and the policies that are currently in effect were kept in place indefinitely, a continued surge in federal debt during the rest of this decade and beyond would raise the risk of a fiscal crisis (in which the government would lose the ability to borrow money at affordable interest rates) and would eventually reduce the nation's output and income below what would occur if the fiscal tightening was allowed to take place as currently set by law.

The actual scenario is even worse than the CBO makes out. If the U.S. national debt continues to explode, then, eventually, when the Federal Reserve raises interest rates to prevent inflation, the rising interest rates will greatly increase the interest component of the federal budget.

From then on, either alternative would be a disaster: (1) the federal government could default, or (2) the Federal Reserve could take the brakes off inflation. In either case, the dollar would collapse in the currency exchange markets, interest rates and import prices would go sky-high, and the U.S. standard of living would hit the bottom with a splat.

Hopefully, Obama and the Republican House will achieve a deal that reduces the budget deficits by at least the $502 billion per year of the fiscal cliff. If not, then a failure in the negotiations would be the best outcome of all.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.